Can Watson Power IBM Stock to New Highs?

Watson the supercomputer is getting its own home in New York City. IBM (IBM) announced on Jan. 9 that it’s creating a separate business unit for the computing system best known for defeating 74-time Jeopardy winner Ken Jennings in 2011.

While it’s not enough to make me want to run out and buy IBM stock, the news sparked my interest in Big Blue. Watson has numerous applications, from business analytics to healthcare diagnoses that could affect IBM stock. The only question is: Will those applications materialize?

Should you have IBM on your buy list at the moment? I’ll have a look.

Watson Powering Business Analytics

Watson is part of IBM’s business analytics software portfolio. The company hopes that Watson will generate $10 billion in annual revenue by 2023; it currently is responsible for less than $100 million of the $20 billion in revenue IBM expects to generate from business analytics and optimization software and services by 2015.

IBM is so convinced of Watson’s potential for solving problems that it has committed more than $1 billion to create the new unit, including a $100 million venture-capital fund that will allow Big Blue to work with startup companies developing apps for Watson and sharing in the revenue.

It’s very early in the process, but several industries including healthcare have benefited from the supercomputer’s ability to analyze vast amounts of information to find answers to problems. As someone who writes about investments for a living, I can easily imagine investment-related businesses benefiting from Watson’s efficient analysis of reams of data.

However, when all is said and done, Watson still represents a tiny fraction of overall revenue at IBM (assuming $10 billion in revenue by 2023). The future success or failure of IBM doesn’t hinge on Watson.

Warren Buffett Likes Watson

Berkshire Hathaway (BRK.B) is the largest shareholder of IBM, with a little more than 6% of its stock. Buffett acquired the shares over a period of 27 months beginning in the first quarter of 2011, paying an average of $173 per share.

As of January 13 those shares have returned a minuscule 6.5% — hardly the stuff of legends. But look more closely and you’ll see that IBMs stock price is trading well below its earnings line, which is based on a P/E ratio of 15, the multiple Peter Lynch used when comparing a stock’s current price to the historical fair value of the market on the whole.

When the green line in the attached chart drops significantly below the blue line, the stock is considered undervalued. Only twice in the past 13 years has this happened for IBM and today is one of them.

Capital Allocation

You can argue all you want about the state of IBM’s business but it’s harder to dispute its ability to successfully allocate capital.